Circular Flow of Money in a Simple Economy

Some of the major sectors in which the real flow takes place in a simple economy are as follows:

A simple economy assumes the existence of only two sectors, i.e. household sector and firm sector.

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1. Households are the owners of factors of production and consumers of goods and services.

2. Firms produce goods and services and sell them to the households.

It is the simplest form of closed economy, in which there is no government sector and foreign trade.

Closed Economy is an economy which has no economic relations with rest of the world. Open Economy is an economy which has economic relations with rest of the world.

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In order to make our analysis simple, we take some assumptions:

1. There are only 2 sectors in the economy Households and Firms. It means, there is no government and foreign sector.

2. Household sector supplies factor services only to firms and the firms hire factor services only from households.

3. Firms produce goods and services and sell their entire output to the households.

4. Households receive factor income for their services and spend the entire amount on consumption of goods and services.

5. There are no savings in the economy i.e. neither the households save from their incomes, nor the firms save from their profits.

The Circular flow in Two-Sector economy can be better understood with the help of Fig. 1.4.

i. The outer loop of diagram shows the real flow, i.e. flow of factor services from households to firms and corresponding flow of goods and services from firms to households.

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ii. The inner loop shows the money flow, i.e. flow of factor payments from firms to households and the corresponding flow of consumption expenditure from households to firms.

It must be noted that entire amount of money, which is paid by firms as factor payments, is paid back by the factor owners to the firms. So, there is a circular and continuous flow of money income. In the circular flow of income, production generates factor income, which is converted into expenditure. This flow of income continues as production is a continuous activity due to never-ending human wants. It makes the flow of income circular.